According to the likes of Mitt Romney, the individual’s relentless pursuit of profit – the organizing principle of the capitalist economy – is as relevant today as it was when Adam Smith published the Wealth of Nations in 1776. Individualism, say its adherents, has always been, and continues to be, the best engine of collective prosperity.
But the champions of individualism are promoting an ideology that is dated and destructive, particularly when it’s applied to business organization. Whatever its virtues during the industrial age, individualism is much less applicable in the information age, in which the main factor of production is ingenuity, products are increasingly intangible, and capital markets are more international than ever before.
Today, individualism is bad for business. And the reason why has much to do with its
impact on the way companies are run.
For over a century, the corporation has been the dominant method of organizing economic activity. As is well known, shareholders provide capital to the corporation, and in return they receive an equity interest and the right to elect its board of directors, which serves as the decision-making body.
Importantly, the rights of shareholders are exclusive, meaning that shareholders are the only constituency of the corporation that has them. Therefore, as a general rule, employees, customers, creditors, governments, and any other group that has a stake in the performance of the corporation have no say over its profits or decisions. If the corporation were a state, it would be a "shareholder dictatorship".
For much of the last century, the seemingly undemocratic structure of the corporation was not necessarily incompatible with economic performance. This is because it was accepted that while corporate decision-makers are formally accountable to shareholders, they should have discretion to consider the interests of other stakeholders as well.
As a result, the corporation looked more like a benevolent dictatorship, in which directors and officers tried to balance shareholders’ desire for profit with the long-term needs of the business and its various constituents.
But in the 1980, this so-called "managerial capitalism" came under attack amid increasing competition from emerging markets, namely Japan. Shareholders complained about declining profits and blamed what they perceived to be bloated organizations and profligate spending, rather than outdated processes and machinery.
Around the same time, shareholders got a major intellectual boost from neoclassical economists, who developed a theory of the corporation that has become known as "shareholder primacy". The fundamental assumption of shareholder primacy is that the corporation is an individualistic entity in which various parties come together to pursue their own interests. True to form, this theory also assumes that the sole concern of each corporate stakeholder is wealth maximization.
According to shareholder primacy, in an environment where each party is only out to enrich itself, shareholders are especially vulnerable to exploitation. They have to trust that managers will always strive to maximize shareholder returns, rather than pursue their own interests, those of the business, or the company's other stakeholders.
The purported vulnerability of shareholders provided an excuse for putting profit maximization at the centre of business organization. This new conception of the corporate objective also fits neatly into the overarching neoclassical narrative, according to which the unfettered pursuit of individual wealth is the basis for economic growth and prosperity.
The emergence of this compelling ideology, combined with the frustration of declining shareholder profits, helped reorient business organization along individualistic lines. Corporate law and practices evolved not just to protect the rights of shareholders, but to put their interests at the heart of the corporation’s activities.
The Failure of Corporate Individualism
For the last three decades, the theory that the corporation is a vehicle for collaboration and the pursuit of collective goals has been largely rejected. Instead, it has been viewed as a tool for advancing the private financial interests of those with sufficient power acquire and dispose of corporate equity. In other words, the utility of the corporation is not measured by the people it employs and the products and services it creates, but the extent to which it can be used generate returns for individual investors.
A case in point is Worldwide Grinding Systems, a Kansas City steel mill founded over a hundred years ago. In 1993, Bain Capital, the private equity firm co-founded by Republican presidential nominee Mitt Romney, engineered a sweetheart deal in which it acquired a majority stake in the company, which was renamed GS Technologies, for $8 million. The following year, Bain directed the company to borrow $125 million, a quarter of which was paid to Bain in the form of a dividend. In just one year, Bain quadrupled its investment, not by making the company more competitive, but by using it as a conduit for borrowed money.
In 1995, Bain gambled on another round of debt financing, this time to facilitate a merger with another steel company. Despite boosting revenues, Bain’s decisions saddled the company with debt, which took a major toll on its bottom line as it faced increasing competition from low-cost countries and declining demand. Eventually, the century-old steel maker was forced to declare bankruptcy, resulting in the closure of its plant in Kansas City and the loss of 750 jobs. To make matters worse, the company required $44 million in federal aid to cover unfunded pension liabilities.
The sad story of GS Technologies is indicative of the triumph of individualism in business organization and its devastating economic consequences. According to Wa study conducted at INSEAD, it has resulted in massive layoffs and underinvestment in machinery, equipment, and skills development. Not surprisingly, the consequence has been declining competitiveness and further downsizing.
In the last decade, the United States has lost over five million manufacturing jobs, many of which would have been saved had businesses done the hard work of investing in their own competitiveness. Instead, they took the easy route to short-term profits by cutting costs or borrowing money to give shareholders returns that their outlook didn't justify.
It’s not hard to see how shareholder primacy, which turns the corporation into a hub of rent-seeking behaviour, is also to blame for other disturbing economic trends, such as ballooning trade deficits and stagnating productivity growth. In addition, shareholder primacy helps explain the rise of outsourcing, the sustained assault on organized labour, and frozen middle-class wages (not to mention grotesque levels of inequality).
And as shareholder primacy pushed jobs overseas and concentrated wealth, the only way to maintain consumer spending and standard of living was to expand the use of credit, which ultimately led to the global financial crisis.
It may seem unreasonable or simplistic to lay all the world’s major economic problems at the feet of shareholder primacy. But while there are certainly other factors at play, it would be a mistake to minimize the macroeconomic impact of business organization.
For the last thirty years, thanks to the harmonizing force of capital markets, investment decisions have been dominated by an ideology that puts individual financial gain ahead of collective economic well-being. Shareholder primacy provided an elegant and convenient justification for the financial elite to indulge in its propensity for greed by sucking much of the dynamism out of the economy.
Individualism in the Information Age
One of the reasons why individualism is such a harmful starting point for organizing business is that it does not reflect modern economic realities. For example, it is widely accepted that human ingenuity is now the most important factor of production, yet businesses are still organized as if capital were the only thing that mattered.
According to a recent study commissioned by the Government of Canada, employees are by far the greatest source of innovative ideas within companies; shareholders don’t even make the list. Nevertheless, under Anglo-American law, employees have no right participate in the management decisions. If innovation is thekey to business success in the information age, then excluding the greatest source of innovation from the boardroom makes no business sense.
Similarly, the fact that products and services are increasingly intangible militates against shareholders dictating business decisions. The lower cost of innovation, particularly in the software sector, means that many companies can be financed with little or no equity investment, thus decreasing the importance of shareholders to the business.
Moreover, in addition to employees, customers are also an important source of new ideas; look at the user-generated content that powers the profits of Facebook and Google. The intangible nature of this output, combined with the diffusion of knowledge and technology, means that customers can easily modify and improve a company’s offerings.
Given their growing importance in the production of goods and services, wouldn’t it be beneficial to have customers involved in business decisions as well? And shouldn’t they be entitled to a share of the profits they help generate?
Finally, the shareholder primacy model is at odds with the internationalization of capital markets, which means that there is no shortage of investors willing to take a risk on a promising company. Scarcer and less mobile are skilled workers, accessible customers, available natural resources, and supportive government policies. Since these factors are the drivers of capital investment, the relevant stakeholders can make a strong case for board-level representation.
If the corporation was not a collective enterprise in the industrial age, then it certainly is in the information age. The production of goods and services today depends on multiple constituencies, each with considerable influence over business outcomes. In this environment, putting the interests of one ahead of all others is incompatible with long-term business performance.
The answer is not to transform stakeholders into shareholders through, for example, employee share ownership plans, as many commentators suggest. Instead of truly opening the boardroom to stakeholders, such so-called "shareholder democracy" gives them the possibility – in the unlikely event that they have enough voting power to elect a meaningful number of directors – of participating in business decisions as shareholders, even though they may not care about profits at all. This is the corporate equivalent of fostering political dissent in China by subsidizing Communist Party memberships.
Fortunately, there are proven collectivist alternatives to the individualistic model of business organization. In the Netherlands, for example, workers participate in the appointment of directors and can veto management decisions that directly affect them. In addition, they have the right to be consulted on major corporate transactions – such as Romney-style takeovers – and have them reviewed by a court. And, unlike in US and UK, shareholders of Dutch companies cannot sue the board simply for failing to maximize returns.
All of this stems from a recognition, articulated in the Dutch Corporate Governance Code, that "a company is a long-term alliance between the various parties involved in the company". This "cooperative capitalism" is practiced in many other Continental European and Nordic countries. In the Netherlands, as elsewhere, it has proven to be compatible with strong economic results. The Dutch economy outperforms the American one in a number of key areas, including per capita GDP, unemployment, current account balance, public debt, and income distribution. In addition, the Netherlands is home to world-class companies such as PhilipsElectronics, Heineken International, and KPMG.
Whether or not Mitt Romney succeeds in becoming President, the individualistic brand of business organization that he helped pioneer has turned out to be an economic failure. It sacrificed long-term competitiveness for short-term profits at all costs for the few. It is inconsistent with the economic realities of the information age, in which production is an increasingly cooperative endeavour.
In the area of economic organization, individualism is bad for business. It’s time to embrace collectivist alternatives.